Fiscal Policy: Principles and Practice
Sarah Love. Sarah is a Research Economist at the Institute for Fiscal Studies.
‘Fiscal policy’ is the term used to describe all of the government’s decisions
regarding taxation and spending. It covers a huge array of taxes, benefits and
public services, and is a powerful tool for changing the performance of the
economy and the distribution of resources. So what makes a ‘good’ fiscal
policy in theory? And how do we run fiscal policy in practice?
Fiscal policy in theory
What a government regards as ‘good’ fiscal policy will depend upon that
government’s political beliefs and objectives. But some general economic
principles apply:
How big should the state be?
What share of national income should be taken in taxation and spent by the
government? Economics tells us that welfare is maximised if the government
spends until the marginal social benefit of the last pound spent equals the
marginal social cost of raising that pound. If the government spent less, then
the benefits from increasing public spending would exceed the costs of raising
more in taxes. If it spent more, then cutting back taxation and spending would
raise social welfare.
What should the state spend money on?
The government should only raise and spend money for reasons of equity or
efficiency.
Equity: Interventions to increase equity range from transfer payments to
disadvantaged individuals or groups to subsidising services such as education,
health and housing.
Efficiency: Public spending can improve efficiency if there are externalities.
An externality is a divergence between an individual’s private marginal cost
of, or benefit from, an activity and the social marginal cost or benefit. The
divergence means that, in the absence of government intervention, the amount
of activity that the individual undertakes is not the amount that would be
optimal for society. If, for instance, people who undertake training raise not
only their own productivity but also others’, then the marginal social benefit of
training exceeds the marginal private benefit. The government could raise
social welfare by intervening to lower the cost of training for individuals.
There are certain items, known as public goods, that are unlikely to be
supplied privately. These goods have two characteristics: (i) they are nonrivalrous, which means that one person can consume them without reducing
the amount available for others to consume; and (ii) they are non-excludable,
ie, the buyer cannot prevent others from using them without paying. Because it
is not possible to exclude non-payers, no one has an incentive to purchase
these items. Each person would rather let someone else pay and ‘free ride’. So
the state intervenes to provide public goods, such as national defence and
street lighting.
In practice, there may be trade-offs between equity and efficiency:
government interventions that improve one of these may worsen the other.
How should the state raise money?
Fairness and efficiency are, once again, important concerns.
Fairness: There are two aspects of fairness for the government to consider:
•
Inter-generational fairness: Different methods of financing spending
spread costs across generations in different ways. Paying for something
out of tax revenues puts the whole cost on today’s taxpayers. Borrowing
money instead means that debt can be repaid by current and future
generations.
•
Intra-generational fairness: There are many ways of collecting revenue.
Governments can tax income, wealth or consumption, to mention but a
few options. The tax itself can be a fixed charge, a flat rate, or a rate that
varies with the amount being taxed. Each tax has different implications
for the distribution of resources.
Efficiency: Taxes also differ in their efficiencies. A tax on earnings, for
example, creates a gap between a worker’s marginal product and her marginal
benefit (the amount she is paid). This gap causes a deadweight loss. Optimal
tax theories provide guidance about whom to tax, and how to tax them, to
minimise deadweight losses across the economy.
Optimal tax theories generally incorporate a social welfare function (which
explains how a society’s welfare depends on the wellbeing of its members), so
they do not ignore the effects that different taxes have on the distribution of
resources. But it is worth noting that, as in the previous section, there are
trade-offs. Maximising the efficiency of a taxation system can conflict with
other objectives, not least achieving certain definitions of fairness.
Fiscal policy in practice
In 1998, the government introduced a Code for Fiscal Stability, setting out
the principles that would guide the making of fiscal policy. The principles
include fairness and efficiency but the Code does not specify what the tradeoff between these two concerns should be. Nor does it discuss how big the
state should be, or what services it should provide. These issues have no
definitive economic answers, so they are decided politically. However, the
government did publish two fiscal rules in the same year. These explain how
the government believes the public finances – ie, the accounting aspects of
fiscal policy, such as borrowing and debt – should be managed.
The sustainable investment rule
This states that the public sector’s debt should be at a “stable and prudent”
level, which the current chancellor judges to be no more than 40% of national
income. There is nothing magic about 40% – it could just as easily be 35% or
45%.
The reason for limiting debt levels is that the government, like individuals, can
only borrow if its creditors – the holders of government bonds – believe the
gains from lending outweigh the risks of non-payment. So bondholders must
believe that the government can meet its debt interest payments. As public
debt increases relative to tax revenues, so do the debt interest payments, which
increases the risk that the government defaults on its debt. Eventually, if this
continues, the result is a debt crisis, like that which took place in Argentina in
2001–02. Although such a crisis is unlikely in the United Kingdom, its
devastating effects make it worth guarding against. Limiting the ratio of
national debt to income to a level that is well within the government’s ability
to repay eliminates the risk of a debt crisis.
The golden rule
This states that the government should only borrow to invest. Accountants
define investment (or capital spending) as spending on lasting assets –
property, machinery, etc. Purchases of non-durable items, such as food and
wages, are current spending. So the golden rule means that the government
has to fund its current spending out of today’s tax receipts. Only capital
spending should be financed by borrowing, which is paid back by future
generations.
The aim of this is to increase inter-generational fairness, which the
government interprets as not making future taxpayers pay for today’s spending
unless that spending purchases assets of lasting benefit. But the rule only
ensures this if the spending financed out of borrowing (ie, capital spending)
benefits future generations and none of the spending financed out of tax
revenues (mainly current spending) does. In practice, this is unlikely to be
true. Spending on schools, for example, is mainly counted as a current
spending item, because its biggest component is teachers’ salaries. But
schooling improves the skills of today’s children, who are future taxpayers,
and increases their future productivity. Although children’s education is not a
tangible asset, it benefits future generations. Conversely, there are certain
items of capital spending, such as the Millennium Dome, which might not be
of significant benefit to future generations.
Ideally, then, we would distinguish more accurately between spending of
benefit to future generations and spending of benefit only to today’s taxpayers
than we do with the existing categories of capital and current spending. But it
would be difficult to decide which spending items fell into which category,
and a chancellor might be tempted to count too much of his or her spending as
beneficial to future generations, in order to finance it through borrowing and
pay for it later. Given the difficulties of drawing up a better rule, allowing only
capital spending to be financed out of borrowing seems a reasonable
approximation of the government’s interpretation of inter-generational
fairness.
The golden rule does not guarantee that the marginal social cost of public
spending will equal the marginal social benefit. So sticking to the rule will not
necessarily make for optimal fiscal policy. But, given the difficulty of
measuring even marginal private costs and benefits, let alone social ones, there
would be no point in passing a rule requiring the two to be equal.
We have seen how the factors that should influence fiscal policy compare to
actual practice. Rather than attempting to run an ‘optimal’ fiscal policy in
some strict and quantifiable sense, the present government has instead chosen
to outline its concerns without committing itself to a given size of state or
viewpoint about the relative importance of equity and efficiency. With respect
to the public finances, the government prefers ‘rules of thumb’ that are likely
to strengthen the link between what each generation pays for and what it
receives, while ensuring that policies are financially sustainable.